My baseline scenario is the US has entered an era of stagnant productivity growth, reductions in consumption driven by the indebted millennial and Z generations, reductions in consumption due to subsidized/inflated real estate (a zero sum game that nonetheless consumes the discretionary income of consumers), reductions in consumption due to demographic graying, rising savings rates, deflationary undertow, and highly indebted zombie corporations. In terms of debt burden and demographics we are Japan circa about 1992, minus the real estate and stock crash - so far.
So while today’s low interest rates are rational for a low growth, disinflationary economy with 1990s Japanese demographics and productivity growth, those low rates have also pushed up corporate leverage, pushed down earnings yields on stocks, and pushed up real estate prices. As Japan showed, this seemingly unbalanced new normal can persist for decades. A relevant question is whether the S&P 500 in a declining growth environment deserves a PE ratio of 23, or if real estate deserves low-single digit cap rates (or the negative cap rates is common in HCOL areas!)?
Japan crashed when people realized it was priced for high growth it could not deliver, and was in fact ensnared in a debt trap. A wise investor once observed that in the event of a disagreement, the bond market is usually right. Nonetheless the odds are high. If the government succeeds at pushing up inflation/ rates, the value of bonds will plummet in a way the US has never seen at the same time the government experiences a debt crisis. That would itself crash the economy on a scale far bigger than subprime home loans 2008. If the bond market is right, stocks do not deserve anything close to their valuations, and average PE ratios should be in the 12-14 range.
The plan? I’m tilting our 401ks towards bonds/cash and our brokerage accounts toward option-protected equity positions (Note: option prices are mathematically derived and therefore unaffected by the bubble, yet can offset equities risk! Bargain!). This is similar to the bond tent approach except (1) I am more exposed to the upside in equities than a majority bond portfolio, (2) I am less exposed to the risk of bond values falling if interest rates rise, (3) I am less exposed to the risk of a broad flight from risk- or a correlation between stock and bond values, and (4) my hedge value has a guaranteed inverse relationship with the underlying, a leveraged negative correlation rather than an unleveraged hypothetical weak correlation as expected with bonds, gold, etc. Our mostly equities NW fluctuates with market movement more like a 30/70 stocks/bonds portfolio, and yet even that overstates the risk and understated the returns because the options don’t move 1:1 with stocks while there is still significant time value remaining. Personal Capital shows our personal rate of return running close to the S&P.
When we’re 25% down, our IPS says our AA shall shift back toward equities.
